Average Profits Method

The Core Idea: Why Pay for "Average" Profits?

When a new partner buys into an existing firm, they pay for goodwill because the business is already earning profits. A brand-new business would typically take a few years to reach that level of earnings. So, the incoming partner compensates the existing partners for the profits they can expect to earn in those early years.

The Average Profits Method values goodwill by multiplying the average profit of the past few years by an agreed number of years (called "years' purchase"). The logic is simple: if the business has been earning ₹20,000 per year on average, and you expect that to continue for the next 3 years, the goodwill is worth ₹60,000 (₹20,000 × 3).

The Simple Average Method

This is the most straightforward approach. You calculate the average profit of the past few years and multiply it by the number of years' purchase.

Formula:

Goodwill = Average Profit × Number of Years' Purchase

Where:

Average Profit = Total Profits of the given years ÷ Number of years

To apply it, total the past years' profits, divide by the number of years to find the average profit, then multiply by the agreed number of years' purchase. This calculation assumes that future profits will remain at the same level as the past average — no trend is considered.

The Weighted Average Method

Sometimes, profits show a clear upward or downward trend. In such cases, giving equal importance to a profit from five years ago and a profit from last year doesn't make sense. Recent years are more indicative of the future.

The Weighted Average Method assigns higher weights to recent years' profits. The textbook specifies that this method should only be used if explicitly stated in the question.

Formula:

Weighted Average Profit = Total of (Profit × Weight) ÷ Total of Weights

Goodwill = Weighted Average Profit × Number of Years' Purchase

Because recent years carry more weight, a firm with rising profits is valued higher than a simple average would suggest, while a firm with falling profits is valued lower — the weighted average pulls the figure toward the most recent performance.

Adjusting Profits Before Calculation

This is where most mistakes happen. The profits given in a question are often not the correct profits for goodwill valuation. You must adjust them for:

1. Abnormal items: Non-recurring expenses or incomes should be removed.
2. Capital vs. Revenue: If a capital expenditure was wrongly charged to revenue, it must be added back.
3. Depreciation: If an asset is capitalised, depreciation on it must be provided.
4. Valuation errors: If closing stock was overvalued or undervalued, profits must be corrected.
5. Management charges: If the owner's salary or management cost is not already accounted for, it must be deducted.

One subtle point under valuation errors: an over- or under-valuation of closing stock in one year automatically distorts the opening stock — and therefore the profit — of the very next year in the opposite direction, so both years must be corrected.

Accounting Treatment

When goodwill is valued using the Average Profits Method and the new partner brings in their share, the journal entry is:

Then, the premium is distributed among the sacrificing partners in their sacrificing ratio:

| Date | Particulars | L.F. | Debit (₹) | Credit (₹) | …